• 2010 Year-End German Law Update
  • January 18, 2011
  • Law Firm: Gibson Dunn Crutcher LLP - Los Angeles Office
  • The improvements in the German economy in 2010 have eased some of the restructuring pain, but have not prevented lawmakers from responding to certain deficiencies that are widely believed to have caused the financial crisis. More attention has been given to board responsibility by tightening requirements for board members' qualifications and extending statutory limitation periods for board member liability. On the financing and restructuring side, courts had ample opportunities to clarify long-debated issues, e.g. the right to terminate comfort letters.

    German companies' heightened awareness of compliance-related issues and the rise of internal investigations have also triggered activity on the end of the enforcement authorities. They have tended to limit the extent of the attorney-client privilege in order to benefit from valuable information created in such investigations, which they believe to be a low-hanging fruit. While the European Court of Justice has confirmed that in-house counsel do not enjoy legal privilege in internal investigations, the German legislature recently took a different direction and clarified that attorneys generally enjoy the same legal privilege as specialized defense counsel.

    German labor courts are notorious for causing raised eyebrows among foreign investors. Most recently, they did it with a landmark decision that does away with the "one business, one union" principle, hitherto a guarantee for relatively smooth and efficient labor disputes with German unions. Moreover, the European Court of Justice has added a new facet to the neverending story of automatic employee transfer in a business transfer by way of an asset deal, adding new complexity to asset deals that lead to a full integration of assets into the acquirer's business. In the antitrust arena, German and EU authorities have imposed new, record high cartel fines and the EU Commission's new settlement procedure has been used for the first time.

    And finally, the cat-and-mouse game enjoyed by tax structuring experts, tax authorities and the legislature has entered a new round with some interesting developments relating to Exit Tax and the CFC Rules -- although this does not come as a surprise, it is likely to continue in this new decade.

    Please enjoy the following update summaries of some of the most noteworthy legal developments that occurred in Germany in 2010.

    Corporate Law

    1.  Required Qualifications for the Independent Financial Expert in the Supervisory Board

    Since May 2009, the German Stock Corporation Act (AktG) has required that the supervisory board of a stock corporation (that is listed or has issued listed bonds, etc.) has an independent financial expert amongst its members. On April 28, 2010, the Munich Higher Regional Court (Oberlandesgericht) clarified the qualifications required of such a financial expert.

    In the past, it had often been argued that only candidates who were either trained as auditors or previously served as chief financial officers on the management board could qualify for such a position. The Munich Higher Regional Court put an end to such restrictive interpretation and held that it is sufficient for the candidate to have relevant experience and professional training in the area of accounting or audits. Such expertise can be gained by prior professional activities at a responsible managerial level. The person must be capable of reviewing and evaluating the accounting procedures and effectiveness of internal control mechanisms (i.e. the risk management system) of the company, as well as supervising the auditors. Other controversial aspects (i.e. the meaning of "independent") have been left open for now.

    2.  Period of Statutory Limitation for Board Members' Liability Extended to Ten Years

    In an effort to further address the consequences of the global financial crisis on German banks and other financial institutions, Germany amended a number of banking and corporate laws with the so-called Restructuring Act (Restrukturierungsgesetz) of December 9, 2010.

    Primarily, the Restructuring Act facilitates the restructuring as well as controlled liquidation of banks in distress. Yet, less noticed by the wider community, the Restructuring Act, with effect as of December 15, 2010, also considerably extended the period of personal liability for actual and former members of the managing board (Vorstand) as well as the supervisory board (Aufsichtsrat) of listed stock corporations in general, by doubling the statute of limitations from five to ten years (starting at the time when the breach of the board member's duty occurred).

    3.  Compensation of Minority Shareholders Meets Reality Test

    In July 2010, the German Federal Supreme Court (Bundesgerichtshof, BGH) finally changed its position with respect to the compensation of minority shareholders in corporate restructurings and squeeze-outs. Under German statutory law, minority shareholders often receive a mandatory cash offer (against surrender of their shares) when the company undergoes significant corporate restructurings, such as a consolidation, a change of corporate form, a squeeze-out or the establishment of a profit-and-loss transfer agreement. These are complex measures that require a general meeting and are particularly relevant when a takeover is implemented or a public company is being taken private.

    In the last decade, the BGH always held that the valuation underlying the mandatory offer must be based on a discounted cash flow analysis and at least be equal to the average stock price during the three month period ending on the day of the general meeting. Since a corporate restructuring of the kind described above generally becomes public several months earlier, the stock price is usually impacted and tends to go up, especially when the free float is small. Now the BGH has acknowledged the constant criticism and agreed (in the case of a minority squeeze-out) that the valuation shall be equal to at least the average stock price during the three months before the publication of the restructuring, i.e. an earlier relevant time period (and lower price ). An adjustment may only be justified if a "longer period" passes between the publication and the general meeting.

    4.  Requirements for Activation of Shelf or Dormant Companies Eased

    In recent years, German courts have hindered the use of dormant or shelf companies (e.g. when structuring an acquisition) by ruling that a new start of economic activity of the company is to be treated as if the company had been newly incorporated (so-called "economic activation," wirtschaftliche Neugrüdung). Thus, the managing directors are required to issue a statement that the registered share capital is untouched when "activating" a shelf company. The same applies to existing companies that are not shelf companies, but have been dormant for some time. If the managing director does not comply, he/she may face liability risks and the corporate veil can potentially be pierced.

    In early 2010, the BGH held that these strict requirements do not apply if a company is incorporated, but instead the actual start of the intended business is extended by the preparation of its operations. Thus, if a company has a corporate purpose (e.g. in this case a language school), preparations are ongoing, but it takes some time to get actually started, the company is not "dormant" and the additional requirements for economic activation do not apply. While this is a helpful clarification for cases where the roll-out of the business activity takes some time, investors should remain mindful of the lingering risks when using dormant or shelf companies and ensure that the registered share capital remains untouched until the managing director has made the appropriate statement vis-à-vis the commercial court.

    Finance/Restructuring

    Terminating Comfort Letters With Short Notice Endorsed

    In a recent decision, the BGH allowed the unilateral termination of a comfort letter. Comfort letters (Patronatserklärungen) are typically issued by direct or indirect parent companies vis-à-vis business partners of their subsidiaries in order to encourage the business partner to contract directly with the subsidiary. Often times, legally binding comfort letters are also issued vis-à-vis the subsidiary itself to prevent the subsidiary from becoming over-indebted.

    In the case before the BGH, the termination declaration was issued without notice and was derived from a contractual right to terminate, since the comfort letter had only been issued to bridge the period until a review of available restructuring options was completed. As a consequence of the termination, the management of the subsidiary had to promptly file for insolvency. The comfort letter reviewed by the court provided that the parent had to indemnify the subsidiary for all obligations which became due while the comfort letter was effective.

    Before the decision, it was under dispute whether or not a comfort letter could be promptly terminated in cases where the subsidiary upon termination had to file for insolvency in a timely manner. The decision has now clarified that even short or nonexistent notice periods are generally permissible, if this is clearly stipulated in the letter itself or a related documentation, and if there is a justifiable reason for the termination.

    Corporate Compliance Matters / White Collar Matters

    Reinforcement of Privilege for Attorneys in Germany by Legislature, but Other Questions Remain Unclear

    While the decision by the European Court of Justice (ECJ) in the Akzo Nobel case, depriving in-house counsel of their legal privilege (see Gibson Dunn Alert, Limited Scope of EU Legal Privilege Confirmed: In-house Counsel Excluded) has caused disappointment with companies, there is at least one encouraging development for a reinforced attorney-client privilege in Germany.

    By amending the Criminal Procedural Code (Strafprozessordnung, StPO), the German legislature has clarified that all attorneys must have the same status as criminal defense lawyers (Strafverteidiger) with regard to the applicability of the attorney-client privilege. The StPO treats criminal defense attorneys and other attorneys differently to some extent. Thus, before the amendment, the attorney-client privilege of "normal" attorneys was weaker than that of their colleagues who are acting in a criminal defense function.

    However, the amendment has still left some uncertainty regarding the situation of attorneys representing the company, not the individual manager, especially when they conduct compliance investigations. This is likely due to the fact that only individuals, but not companies, can be subject to criminal investigations under German law. Also, internal investigations are still a recent development in Germany, which has not been adequately acknowledged and considered by the legislature.

    As internal investigations handled by law firms are becoming a standard feature to protect companies from fraud and compliance violations, we are expecting more litigation around and decisions about this subject in the near future, which is likely to render more certainty in this regard.

    Employment Law

    1.  More than one Union per Business Permissible

    In a widely-noticed judgment, the German Federal Labor Court rendered a landmark decision that will influence future labor relations in Germany. The court dismissed the practice widely known as "One business -- One union" (Eine Betrieb, eine Gewerkschaft), according to which only one collective agreement could apply to any given business (Betrieb). As a consequence, more than one union may now demand to negotiate a separate collective agreement for its members working at a given business and emphasize its claims by way of strikes. As an example, an airline would usually negotiate agreements with "Verdi", the major union representing service staff. However, pilots have their own niche union, leveraging the group's greater bargaining power to press for more favorable employment conditions and salaries. The same is seen with doctors' unions in hospitals that wish to have their higher paid clientele treated differently from other service staff; railroad engineers and similar groups of expert staff are also often times unionized in special unions. In order to avoid disruptions caused by uncoordinated strikes of several unions, the legislature is examining setting certain limits on the divergence of the union landscape, but so far no specific solution has been decided upon.

    2.  European Court Widens Scope for Transfer Of Business under German Law (Betriebsübergang)

    Acquirers of a German business can no longer rely on a narrow interpretation maintained by the German Federal Labor Court (Bundesarbeitsgericht, BAG) regarding the transfer of employees triggered by the acquisition of a business. The German courts had not granted such a transfer if the transferred business was fully integrated into the acquirer's business organization, dissolving the transferred business's previous organization.

    The European Court of Justice (ECJ) has now overruled the German precedents. It has clarified that the European Directive 2001/23 must be interpreted more widely: In cases where a "functional connection" between the transferred assets is maintained, enabling the acquirer to use these assets to carry out an identical or similar business activity, the transferred business is deemed to have maintained its entirety. Consequently, the acquirer cannot limit the transaction to the tangible and intangible business assets or any number of suitable employees, but must assume all the employees originally associated with the transferred business.

    Antitrust

    In 2010, the European Commission and the German Federal Cartel Office ("FCO") continued and intensified their efforts in pursuing and harshly prosecuting cartels. The European Commission adopted 69 decisions (compared to 43 decisions in 2009) and imposed fines totaling over € 3 billion (compared to € 1.6 billion in 2009). Additionally, the German FCO imposed significant fines totaling € 255 million in 11 cases and conducted 17 national dawn raids at 120 companies. These enormous levels of fines imposed by the European Commission and the FCO far exceed the level of fines in the U.S., where the Department of Justice imposed fines totaling $ 555 million in 2010 -- compared to over $ 1 billion in 2009.

    A draft demerger bill (Entflechtungsgesetz), which is intended to allow German authorities the means to demerge market dominant companies as an ultima ratio even if the respective company had not abused its dominance, was presented in January 2010. The draft bill has faced a lot of criticism. However, the German Secretary of Commerce has announced continued efforts to push the bill forward.

    The European Commission adopted its first settlement decision in a cartel case on May 19, 2010. The settlement procedure is aimed at simplifying cartel investigation procedures in order to free up Commission resources that would be blocked from inspecting other suspected cartels by long-running antitrust investigations. In a settlement, companies, having seen the evidence the Commission has on file, can receive a 10% reduction of the fine that would have been imposed in a cartel decision by acknowledging their involvement in a cartel.

    Revised rules on horizontal co-operations were finally adopted on December 14, 2010. The main modifications to the Commission's Horizontal Guidelines, as well as to the Block Exemption Regulations for R&D and specialization agreements, concern the introduction of a new chapter on information exchange in the Horizontal Guidelines and a revision of the provisions relating to standardization agreements in order to promote increased transparency of licensing costs for IP rights. A major amendment to the R&D Block Exemption Regulation concerns the inclusion of "paid for research" agreements and an extended scope for joint exploitation of R&D results.

    Tax Law -- The Annual Tax Act 2010

    German tax practitioners sighed with relief in 2010, since changes to the law were less numerous than in previous years. However, other than two long-awaited decrees on the exemption from real-estate transfer tax for certain restructurings and the tax treatment of partnerships under tax treaties, the Annual Tax Act (Jahressteuergesetz) 2010, adopted on November 26, 2010, provides for some interesting tax news in the context of international and corporate tax law. The most noteworthy news relates to (a) the change-of-control clause, (b) the exit tax rules and (c) the German CFC rules.

    1.  Revised Calculation of Hidden Reserves under the Change-of-Control Clause

    Under the existing change-of-control clause, a transfer of more than 25%, but less than 50%, of the shares in a loss-making corporation to new shareholders within a period of five years results in a forfeiture of current losses and loss carry-forwards on a pro rata basis of the shares transferred. If more than 50% of the shares in the loss-making corporation are transferred, all current losses and loss carry-forwards are forfeited.

    The most relevant existing exemption to this rule stipulates that losses shall not be forfeited upon a share transfer up to the amount of hidden reserves of the loss-making corporation. The Annual Tax Act 2010 has now clarified this exemption: The new law stipulates that the hidden reserves must derive from assets that are taxable in Germany (rather than assets that are located in Germany, as previously worded). Accordingly, hidden reserves in non-tax-exempt foreign branches (e.g., in the absence of a tax treaty) will be able to qualify for the exception.

    Furthermore, where the loss-making corporation has negative equity, the amount of hidden reserves that protect loss carry-forwards from forfeiture will be determined as the difference between the negative equity and the fair market value of the assets of the corporation, rather than the fair market value of the shares in the corporation (as previously worded). This amendment in the Annual Tax Act 2010 does have a significant effect on the use of loss carry-forwards for a buyer acquiring the shares in a corporation with negative equity: Assume the buyer acquires the shares for 100, the equity is (1000) and loss carry-forwards are 1500. If the fair market value of the assets equals the equity, under the previous wording the buyer could have used 1100 of loss carry-forwards (100-(1000)) whereas, after the new wording, all loss carry-forwards are forfeited ((1000)-(1000)=0). The new wording of the change-of-control clause will be applicable as of January 1, 2010.

    2.  Exit Tax Rules Revised and Tightened

    Under the rules amended by the Annual Tax Act 2010, the transfer of assets held by a German corporation in a foreign permanent establishment (PE) will trigger exit tax on the entire hidden reserves. This amendment is a reaction to several Federal Tax Court decisions on the right to tax hidden reserves upon a transfer of assets and businesses abroad. By stating that neither the transfer of a single asset nor the transfer of a business as such results in a loss of Germany's taxing right, the Federal Tax Court held that there is no legal basis to tax hidden reserves on assets transferred at the time of the transfer. The amendment in the Annual Tax Act 2010 provides that a transfer of assets or a business will trigger exit tax immediately, regardless of whether the transfer affects Germany's right to tax the hidden reserves. As is already the case in a transfer of assets, gains on the transfer of a business triggered by the application of the rule may be spread over a five-year period upon application of the taxpayer, provided the business is transferred to an EU/EEA member state and certain conditions are met. The new provisions will be applicable to all cases where income tax has not yet been finally assessed.

    3.  Amendments of CFC Rules - Assault on the Maltese Fortress

    Under the German CFC rules, profits of a foreign company are taxable at the level of the German shareholder (regardless of a profit distribution), if the foreign company is German-controlled (typically a German shareholding above 50%), the foreign company derives passive income and the income is low-taxed, i.e. below 25%.

    The Annual Tax Act 2010 addresses the qualification of "low-taxation" and takes into account tax credits and refunds at the shareholder level when determining whether the effective tax rate of the foreign company falls below the 25% threshold. The amendments target the "Malta model" which has been used in the past by multinationals with German subsidiaries to circumvent the German CFC rules on passive financing income. Corporations established in Malta are subject to a 35% income tax rate. At the same time, a relief is granted to the shareholder in order to reduce the total effective tax liability of the Maltese corporation and the shareholder. Under certain requirements, the shareholder in a Maltese corporation receives a tax refund of up to 6/7 of the taxes paid by the Maltese corporation. Under the new CFC rules as amended by the Annual Tax Act 2010, a corporation resident in Malta will be regarded as low-taxed if the German shareholder receives a tax refund on taxes paid by the Maltese corporation that results in an effective tax rate of less than 25% of the Maltese corporation's profit. The amendments will apply to profits earned by low-taxed foreign corporations in fiscal years starting after December 31, 2010.